Equity Financing vs. Debt Financing
Debt Financing and Equity Financing is the most common method by which companies raise capital (money) from the general public.
Every company needs capital for either growth (new projects) or to fund its working capital requirements (cost of raw material, worker’s salaries, factory rent, and other expenses).
Debt Financing is when a company raises capital from the market by selling its debt i.e. bonds, debentures, bills and notes to retail or institutional investors.
Equity Financing refers to raising capital from the market by selling a portion of equity i.e. ownership of the company.
What is Debt Financing?
In debt financing, companies sell bonds, debentures, bills and notes to the lenders to raise capital.
The lenders become creditors of the company by providing a loan at a fixed rate of interest and tenure. The company, in turn, promises to repay the loan and make timely interest payments.
Unlike equity financing, debt financing is a loan and needs to be compulsorily paid back to the lenders. Even if a company goes bankrupt, the creditors will be paid before the equity shareholders.
What is Equity Financing?
In Equity financing, companies sell a portion of their equity i.e. ownership to the general public to raise capital. Equity Financing is a method of generating additional capital without increasing the company’s debt or financial burden.
Equity financing increases the number of equity shareholders and the owner’s stake in the overall company reduces.
Since equity shareholders are owners of the company, there is no obligation on the company to pay back the capital. Also, the owner is not the sole decision maker as the equity shareholders get the right to vote on important decisions of the company.
Examples of equity financing and debt financing
Let us assume, Mr Kohli, the owner of ABC Ltd wants Rs 10 crores to start a new project. Mr Dhoni, an investor is willing to give him Rs 10 crores. Mr Kohli now has two options:
- Debt Financing: He can either take a loan from Dhoni for Rs 10 crores, pay a monthly interest rate on the loan and repay the loan on time after a specific period. Or,
- Equity Financing: He can sell 10% of his ownership in the company to Dhoni and get the capital without worrying about the repayment.
By selecting debt financing, Kohli can retain 100% of the control in the company but will have the burden of the loan and interest repayment. He will also be spending a big chunk of his profits to pay the interest on loan.
On the contrary, by selecting equity financing, he will get the Rs 10 crores without any repayment burden. But he will have to involve Dhoni in all future decisions.
7 key questions to ask before selecting between debt financing and equity financing
Financing is a critical decision for the company and they need to ensure that they select the best option for their growth.
The basic questions to ask before choosing between equity financing or debt financing are:
- Do you want to retain 100% control of the business?
- Can you make regular interest payment with the current business cash flow?
- Do you qualify for debt financing?
- Do you have a good credit rating in the market?
- Do you have ample collaterals for debt financing?
- Are you comfortable in sharing your future profits?
- Are you comfortable in paying a high interest rate on debt financing?
Equity Financing Vs. Debt Financing – Which is the best option?
|Factors||Equity Financing||Debt Financing|
|100% ownership||In equity financing, you sell a portion of your ownership to raise capital||In debt financing, you can retain 100% ownership and control of your company.|
|Repayment of capital||You do not have to repay the capital to equity shareholders.||You will have to repay the loan on the maturity date.|
|Compulsory Payout||In equity financing, there are no compulsory payouts. The dividends are payable only if there is enough profit and at the discretion of the management.||You will have to make timely payment of interest on the loan taken. A failure to do so can ruin your reputation and credit rating.|
|Event of Bankruptcy||In the event of bankruptcy, the equity shareholders are paid last.||In the event of bankruptcy, the creditors are paid first. So, the loan is secured against business assets.|
|Business Risk||Since equity shareholders are owners of the company, they also share the losses of the company. There is no guarantee of dividends or profits.||Creditors are only lenders and do not have to worry about business losses as they will get their interest and money back even if the business makes no money. .|
Both equity financing and debt financing have pros and cons and there is no ideal debt-to-equity ratio. Companies should work out a balanced capital structure which includes both debt financing and equity financing as per their requirements.